Category: Financial Services Law

Filing Requirements Under the Corporate Transparency Act: Stealth Beneficial Owners

The Corporate Transparency Act (“CTA”) requires most entities to file with the Financial Crimes Enforcement Network (“FinCEN,” a Bureau of the U.S. Department of the Treasury) Beneficial Ownership Information (“BOI”) about the individual persons who own and/or control the entities, unless an entity is exempt under the CTA from the filing requirement. There are civil and criminal penalties for failing to comply with this requirement.

A key issue: WHO are the Beneficial Owners?

FinCEN has issued a series of Frequently Asked Questions along with responses providing guidance on the issue of who the beneficial owners are.

Question A-1, issued on March 24, 2023, states that “[BOI] refers to identifying information about the individuals who directly or indirectly own or control a company.”

Question A-2, issued on Sept. 18, 2023: Why do companies have to report beneficial ownership information to the U.S Department of the Treasury? defines the CTA as “…part of the U.S. government’s efforts to make it harder for bad actors to hide or benefit from their ill-gotten gains through shell companies or other opaque ownership structures.”

Question D-1, updated April 18, 2024: Who is a beneficial owner of a reporting company? states that “A beneficial owner is an individual who either directly or indirectly (i) exercises substantial control over a reporting company” and, in referring to Question D-2 (What is substantial control?), “owns or controls at least 25 percent of a reporting company’s ownership interests.”

Question D-1 goes on to note that beneficial owners must be individuals, i.e., natural persons. This guidance is extended by Question D-2 on Substantial Control, where control includes the power of an individual who is an “important decision-maker.” Question D-3 (What are important decisions?) identifies “important decisions” with a pictorial chart of subject matters that FinCEN considers important, such as the type of business, the design of necessary financings, and the structure of the entity. Question D-4 explores ownership interests (again with a pictorial) including equity interests, profit interests, convertible securities, options, or “any other instrument, contract, arrangement, understanding, relationship, or mechanism used to establish ownership.”

Who, in FinCEN’s view, has “substantial control”?

Question D-2 lists four categories of those who have substantial control:

  1. A senior officer, including both executive officers and anyone “who performs a similar function;”
  2. An individual with “authority to appoint or remove certain officers or directors;”
  3. An individual who is an important decision-maker; or
  4. An individual with “any other form of substantial control.”

“Silent partners” and/or other undisclosed principals, including some who may be using the reporting company for nefarious purposes, might be discussed here, but that is not the intended subject of this writing. Rather, this piece is intended to warn businesspersons and their advisers of potential “stealth beneficial owners” – those whose status as beneficial owners is not immediately obvious.

First, consider the typical limited liability company Operating Agreement for an LLC with enough members and distribution of ownership interests so that no member owns over 25% of the LLC’s equity. If the LLC is manager-managed, then the manager(s) is/are Beneficial Owners, but the other members are not. But what if the Operating Agreement requires a majority or super-majority vote to approve certain transactions? Assuming that those transactions are “important” (as discussed in Question D-3), then possessing a potential veto power makes EACH member a beneficial owner. Such contractual limitations on executive power necessarily raise the issue of “beneficial ownership” in corporations, in limited liability companies, and even in limited partnerships where the Limited Partners have power to constrain the general partner (who clearly is a beneficial owner).

Second, consider the very recent amendments to the Delaware General Corporation Law (“DGCL”) in response to the Delaware Chancery Court’s holding in West Palm Beach Firefighters’ Pension Fund v. Moelis & Co (“Moelis”) Feb. 23, 2024. In Moelis, the CEO had a contract with the Company that materially limited the power of the Board of Directors to act in a significant number of matters. Vice Chancellor Travis Laster issued a 133-page opinion finding the agreement was invalid, as it violated the Delaware Law that placed management and governance responsibilities in the Board. Because such arrangements are frequently used in venture capital arrangements as part of raising capital for new enterprises, the Delaware Legislature and the State’s Governor enacted amendments to the DGCL that expressly authorize such contracts. In the Moelis situation itself, Ken Moelis was a major owner and CEO so he would have had to be disclosed as a Beneficial Owner if Moelis & Co. had not been exempt from the filing requirements of the CTA because it is a registered investment bank.

But what of a start-up venture entity where a wealthy venture investor owns a 10% interest in the entity, but has a stockholder agreement that gives him substantial governance rights including the ability to veto or even overrule board decisions? Is that venture investor not a “beneficial owner”? Somewhat even more Baroque, what about the private equity fund controlled by a dominant investor, say William Ackman or Nelson Peltz? If that fund invests in the same start-up entity and holds a 10% interest, but also has a stockholder agreement giving the fund substantial governance rights, isn’t the controlling owner of the fund a “beneficial owner” of the start-up?

Finally, consider financing with a “bankruptcy remote entity” where the Board of that entity includes a contingent director chosen by the finance source. The contingent director does not participate in any part of the governance of the entity unless the entity finds itself in financial distress. The organizational documents of the entity provide that at that point, the contingent director can veto any decision to file for bankruptcy protection. At that point, the contingent director apparently becomes a “beneficial owner” of the entity, with the CTA filing requirements applicable. A more interesting question is whether the contingency arrangement in the organizational documents makes the contingent director a “beneficial owner” from the inception of the financing. Further, with respect to bankruptcy, key questions remain unanswered, such as whether the trustee in a Chapter 7 bankruptcy proceeding or a liquidating trustee in a Chapter 11 bankruptcy proceeding has a reporting obligation under the CTA.

This piece is not intended to identify all the situations that may give rise to “Stealth Beneficial Owners.” Rather, its intent is to raise awareness of the complexities involved in answering the initial question – WHO is a “beneficial owner”?

©2024 Norris McLaughlin P.A., All Rights Reserved

FinCEN Publishes Updated FAQs

Entities terminated in 2024 are required to file Corporate Transparency Act beneficial ownership information reports, as are administratively dissolved entities.

The Financial Crimes Enforcement Network (“FinCEN”) recently published updates to its list of Frequently Asked Questions (“FAQs”) to assist entities in complying with the beneficial ownership reporting requirements of the Corporate Transparency Act (“CTA”).

Principal among these updates was FinCEN’s clarifying requirement that business entities terminated in the year 2024 (whether existing prior to 2024 or formed in 2024) are required to file beneficial ownership information reports (BOIR) under the CTA.

This filing requirement also expressly includes BOIR filings for administratively dissolved entities.

Each of these concepts were the subject of debate as to their applicability under the CTA prior to this FAQ release, with some conjecture that terminating an entity’s existence prior to its BOIR filing deadline would alleviate the need to make a BOIR filing – a position now refuted by FinCEN.

As Polsinelli has consistently advised, the obligation to file under the CTA has accrued for all entities in existence in 2024, only the deadline for filing the BOIR has not yet arrived. Entities are advised to file their BOIR prior to consummating their termination process.

The July 8 FAQs also included clarification on beneficial owner disclosure scenarios involving an entity fully or partially owned by an Indian Tribe.

FinCEN expects to publish further guidance in the future. The updated FAQs can be accessed here.

* * * * *

Several of the updates bear special note:

1. FAQ C. 12. – Reporting Company Status

Do beneficial ownership information reporting requirements apply to companies created or registered before the Corporate Transparency Act was enacted (January 1, 2021)?

FinCEN stated “Yes.” Beneficial ownership information reporting requirements apply to all companies that qualify as “reporting companies”, regardless of when they were created or registered. Companies are not required to report beneficial ownership information to FinCEN if they are exempt or ceased to exist (i.e., are formally terminated with the Secretary of State) as legal entities before January 1, 2024.

2. FAQ C. 13. – Reporting Company Status

Is a company required to report its beneficial ownership information to FinCEN if the company ceased to exist before reporting requirements went into effect on January 1, 2024?

A company is not required to report its beneficial ownership information to FinCEN if it ceased to exist as a legal entity (i.e., was formally terminated with the Secretary of State) before January 1, 2024. This means that the entity entirely completed the process of formally and irrevocably dissolving (i.e., was formally terminated with the Secretary of State). A company that ceased to exist as a legal entity before the beneficial ownership information reporting requirements became effective January 1, 2024, was never subject to the reporting requirements and thus is not required to report its beneficial ownership information to FinCEN.

Although state or Tribal law may vary, a company typically completes the process of formally and irrevocably dissolving by, for example, filing dissolution paperwork with its jurisdiction of creation or registration, receiving written confirmation of dissolution, paying related taxes or fees, ceasing to conduct any business, and winding up its affairs (e.g., fully liquidating itself and closing all bank accounts).

If a reporting company continued to exist as a legal entity for any period of time on or after January 1, 2024 (i.e., did not entirely complete the process of formally and irrevocably dissolving (i.e., terminating) before January 1, 2024), then it is required to report its beneficial ownership information to FinCEN, even if the company had wound up its affairs and ceased conducting business before January 1, 2024.

Similarly, if a reporting company was created or registered on or after January 1, 2024, and subsequently ceased to exist, then it is required to report its beneficial ownership information to FinCEN—even if it ceased to exist before its initial beneficial ownership information report was due.

A company that is administratively dissolved or suspended—because, for example, it failed to pay a filing fee or comply with certain jurisdictional requirements—generally does not cease to exist as a legal entity unless the dissolution or suspension becomes permanent. Until the dissolution becomes permanent, such a company is required to report its beneficial ownership information to FinCEN.

3. FAQ C. 14. – Reporting Company Status

If a reporting company created or registered in 2024 or later winds up its affairs and ceases to exist before its initial BOI report is due to FinCEN, is the company still required to submit that initial report?

FinCEN stated “Yes.” Reporting companies created or registered in 2024 must report their beneficial ownership information to FinCEN within 90 days of receiving actual or public notice of creation or registration. Reporting companies created or registered in 2025 or later must report their beneficial ownership information to FinCEN within 30 days of receiving actual or public notice of creation or registration. These obligations remain applicable to reporting companies that cease to exist as legal entities—meaning wound up their affairs, ceased conducting business, and entirely completed the process of formally and irrevocably dissolving—before their initial beneficial ownership reports are due.

It bears note that, if a reporting company files an initial beneficial ownership information report and then ceases to exist, then there is no requirement for the reporting company to file an additional report with FinCEN noting that the company has ceased to exist.

4. FAQ D. 17. – Beneficial Owner

Who should an entity fully or partially owned by an Indian Tribe report as its beneficial owner(s)?

An Indian Tribe is not an individual, and thus should not be reported as an entity’s beneficial owner, even if it exercises substantial control over an entity or owns or controls 25 percent or more of the entity’s ownership interests. However, entities in which Tribes have ownership interests may still have to report one or more individuals as beneficial owners in certain circumstances.

Entity Is a Tribal Governmental Authority. An entity is not a reporting company—and thus does not need to report beneficial ownership information at all—if it is a “governmental authority,” meaning an entity that is (1) established under the laws of the United States, an Indian Tribe, a State, or a political subdivision of a State, or under an interstate compact between two or more States, and that (2) exercises governmental authority on behalf of the United States or any such Indian Tribe, State, or political subdivision. This category includes tribally chartered corporations and state-chartered Tribal entities if those corporations or entities exercise governmental authority on a Tribe’s behalf.

Entity’s Ownership Interests Are Controlled or Wholly Owned by a Tribal Governmental Authority. A subsidiary of a Tribal governmental authority is likewise exempt from BOI reporting requirements if its ownership interests are entirely controlled or wholly owned by the Tribal governmental authority.

Entity Is Partially Owned by a Tribe (and Is Not Exempt). A non-exempt entity partially owned by an Indian Tribe should report as beneficial owners all individuals exercising substantial control over it, including individuals who are exercising substantial control on behalf of an Indian Tribe or its governmental authority. The entity should also report any individuals who directly or indirectly own or control at least 25 percent or more of the ownership interests of the reporting company. (However, if any of these individuals own or control these ownership interests exclusively through an exempt entity or a combination of exempt entities, then the reporting company may report the name(s) of the exempt entity or entities in lieu of the individual beneficial owner.)

© Polsinelli PC, Polsinelli LLP in California

Investing in SAFE and Convertible Note Rounds ꟷKnow Your Bedmates!

Early-stage companies often rely on Simple Agreements for Future Equity (SAFEs) and convertible promissory notes to raise capital either prior to a company’s first priced preferred equity round, or to raise bridge capital between priced equity raises. In addition to the economic terms, investors considering participation in these financings should seek visibility as to the other investors in the round, and the potential misalignment of incentives among those investors.

Raising funds via SAFEs and convertible notes has a number of advantages for the issuer, not least of which is the speed with which such financings can be achieved. SAFE and convertible note financings involve significantly less documentation, legal lift, and expense than a standard preferred stock financing. Further, depending on how a SAFE or convertible note is structured, it can allow an early-stage company experiencing rapid growth (and, accordingly, valuation) to raise capital without selling equity at a valuation materially lower than the valuation it can justify in the next 12-24 months.

Similarly, SAFEs and convertible note rounds can appeal to early-stage investors. Again, the documentation is relatively straightforward and, to a large extent, consistent from transaction to transaction. Further, more recent iterations of Y-Combinator’s form SAFE include investor-favorite provisions that protect investors from dilution associated with the issuance of other convertible instruments.

That said, most SAFEs and convertible promissory notes include amendment provisions providing that their terms can be amended or waived with the approval of holders representing a majority of the total invested amount. Such amendments can fundamentally change the terms on which investors originally based their decision to participate in the SAFE or note round. For example, common amendments include reductions in the conversion discount, valuation cap, and/or required equity financing threshold at which the SAFE or note is required to convert. Perhaps more drastic, we increasingly see companies raising significant funds in multiple SAFE or note rounds without ever needing to do an equity financing prior to a liquidity event. In those instances, it is not uncommon for the company to get a majority-in-interest of the SAFE or noteholders to convert into equity on terms that bear little or no relation to what was contemplated in the original investment instrument.

Of course, you may ask, why would a majority-in-interest of the SAFE or noteholders agree to an amendment or adjustment that is not in their best interests? The answer is that savvy founders will often ensure that a majority-in-interest of the investors are “company-friendly,” with incentives that may be very different than those of a passive investor. For example, founders and their friends and family may control a majority of the round. Similarly, SAFE and noteholders may already have equity interests in the company, such that they see a net benefit to agreeing to changes in their note or SAFE terms that, viewed in isolation, are subpar.

Accordingly, before making a material investment in a SAFE or convertible note financing, investors should have a clear understanding of the maximum amount that can be raised, and the likelihood that a significant number of those investors may sign off on amendments that undermine the original deal terms.

© 2024 Winstead PC.

Understanding the Enhanced Regulation S-P Requirements

On May 16, 2024, the Securities and Exchange Commission adopted amendments to Regulation S-P, the regulation that governs the treatment of nonpublic personal information about consumers by certain financial institutions. The amendments apply to broker-dealers, investment companies, and registered investment advisers (collectively, “covered institutions”) and are designed to modernize and enhance the protection of consumer financial information. Regulation S-P continues to require covered institutions to implement written polices and procedures to safeguard customer records and information (the “safeguards rule”), properly dispose of consumer information to protect against unauthorized use (the “disposal rule”), and implementation of a privacy policy notice containing an opt out option. Registered investment advisers with over $1.5 billion in assets under management will have until November 16, 2025 (18 months) to comply, those entities with less will have until May 16, 2026 (24 months) to comply.

Incident Response Program

Covered institutions will have to implement an Incident Response Program (the “Program”) to their written policies and procedures if they have not already done so. The Program must be designed to detect, respond to, and recover customer information from unauthorized third parties. The nature and scope of the incident must be documented with further steps taken to prevent additional unauthorized use. Covered institutions will also be responsible for adopting procedures regarding the oversight of third-party service providers that are receiving, maintaining, processing, or accessing their client’s data. The safeguard rule and disposal rule require that nonpublic personal information received from a third-party about their customers should be treated the same as if it were your own client.

Customer Notification Requirement

The amendments require covered institutions to notify affected individuals whose sensitive customer information was, or is reasonably likely to have been, accessed or used without authorization. The amendments require a covered institution to provide the notice as soon as practicable, but not later than 30 days, after becoming aware that unauthorized access to or use of customer information has occurred or is reasonably likely to have occurred. The notices must include details about the incident, the breached data, and how affected individuals can respond to the breach to protect themselves. A covered institution is not required to provide the notification if it determines that the sensitive customer information has not been, and is not reasonably likely to be, used in a manner that would result in substantial harm or inconvenience. To the extent a covered institution will have a notification obligation under both the final amendments and a similar state law, a covered institution may be able to provide one notice to satisfy notification obligations under both the final amendments and the state law, provided that the notice includes all information required under both the final amendments and the state law, which may reduce the number of notices an individual receives.

Recordkeeping

Covered institutions will have to make and maintain the following in their books and records:

  • Written policies and procedures required to be adopted and implemented pursuant to the Safeguards Rule, including the incident response program;
  • Written documentation of any detected unauthorized access to or use of customer information, as well as any response to and recovery from such unauthorized access to or use of customer information required by the incident response program;
  • Written documentation of any investigation and determination made regarding whether notification to customers is required, including the basis for any determination made and any written documentation from the United States Attorney General related to a delay in notice, as well as a copy of any notice transmitted following such determination;
  • Written policies and procedures required as part of service provider oversight;
  • Written documentation of any contract entered into pursuant to the service provider oversight requirements; and
  • Written policies and procedures required to be adopted and implemented for the Disposal Rule.

Registered investment advisers will be required to preserve these records for five years, the first two in an easily accessible place.

COPYRIGHT © 2024, STARK & STARK
For more news on SEC Amended Regulations, visit the NLR Securities & SEC section.

Paperless Power: Exploring the Legal Landscape of E-Signatures and eNotes

In an era characterized by rapid technological advancements and the profound shift towards remote work, the traditional concept of signing documents with pen and paper has evolved. Electronic signatures, or e-signatures, have emerged as a convenient and efficient alternative, promising to streamline processes, reduce paperwork, and enhance accessibility. Organizations are increasingly embracing e-signatures for a wide range of transactions, prompting a closer examination of their legal validity.

WHAT IS AN “E-SIGNATURE”?

An e-signature encompasses any electronic sound, symbol, or process associated with a record and executed with the intent to sign. These can range from scanned images of handwritten signatures to digital representations generated by specialized software.

GOVERNING LAW:

The governing law for e-signatures in the United States includes both state-specific laws, like those based on the Uniform Electronic Transactions Act (UETA), and the federal ESIGN. ESIGN applies to interstate and foreign transactions, harmonizing electronic transactions across state lines. Many states, including Massachusetts, have adopted UETA, reinforcing the legal standing of e-signatures within their jurisdictions (MUETA).

VALIDITY AND REQUIREMENTS:

Generally, e-signatures are legally binding in the Commonwealth of Massachusetts. However, certain documents like wills, adoption papers, and divorce decrees are excluded from the scope of ESIGN and MUETA to safeguard consumer rights and maintain traditional legal practices.

The following components must be present for e-signatures to be fully protected and upheld under ESIGN and MUETA:

  • Intent: each party intended to execute the document;
  • Consent: there must be express or implied consent from the parties to do business electronically (under MUETA, consumer consent disclosures may also be required). In addition, signers should also have the option to opt-out;
  • Association: the e-signature must be “associated” with the document it is intended to authenticate; and
  • Record Retention: records of the transaction and e-signature must be retained electronically.

Meeting these requirements ensures that e-signatures have the same legal validity and enforceability as traditional handwritten, wet-ink signatures in Massachusetts.

ENFORCEABILITY OF E-NOTES AND CONCERNS FOR FINANCIAL INSTITUTIONS:

An eNote is an electronically created, signed, and stored promissory note. It differs from scanned signatures on paper or PDF copies. Governed by Article 3 of the Uniform Commercial Code (UCC), eNotes are considered negotiable instruments and therefore require special treatment. ESIGN provides a framework for their use, emphasizing the concept of a “transferable record.” This electronic record, meeting UCC standards, grants the same legal rights as a traditional paper note to the person in “control.” The objective of “control” is for there to be a single authoritative copy of the promissory note that is unique, identifiable, and unalterable. Therefore, proving authenticity and lender control over eNotes can be complex.

In Massachusetts, specific foreclosure laws require the presentation of the original note. Thus lenders should be cautious with eNotes, as possessing an original, physical note greatly reduces enforceability risks.

Further, financial institutions often face heightened scrutiny when using e-signatures due to the sensitive nature of financial transactions and the potential risks involved to ensure security, compliance, and consumer protection.

RECORDABLE DOCUMENTS:

E-signatures have become widely accepted for recording purposes, including in real estate transactions, due to their convenience and efficiency. The implementation of e-signatures for recording has been facilitated and standardized by legislation such as the Uniform Real Property Electronic Recording Act (URPERA). While URPERA offers a comprehensive framework for electronic recording, its adoption varies from state to state. In Massachusetts, URPERA has not yet been formally adopted, leaving recording procedures subject to individual county regulations.

BEST PRACTICES:

Despite the legal recognition of e-signatures under both ESIGN and MUETA, to ensure compliance, organizations should adopt the following best practices:

  1. Obtain Consent: Obtain (and retain) affirmative consent from parties to conduct transactions electronically.
  2. Association: Establish a clear and direct connection between an electronic signature and the electronic record it is intended to authenticate.
    • Embedding: One common method of meeting the association requirement is embedding e-signatures directly within electronic documents.
    • Metadata and Audit Trails: Another method is using metadata and audit trails. Metadata contains signature details like signing date, time, signer identity, and transaction specifics. Audit trails chronicle all document actions, reinforcing the link between signatures and records.
  3. Ensure the Integrity of Electronic Records
    • Authenticity and Integrity: Use secure methods to authenticate the identity of signatories and ensure the integrity of the electronic records. This can include digital signatures, encryption, and secure access controls.
    • Single Authoritative Copy: For transferable records (eNotes), ensure that there is a single authoritative copy that is unique, identifiable, and unalterable except through authorized actions.
  4. Maintain Accessibility and Retainability: Ensure that electronic records are retained in a format that is accessible and readable for the required retention period. This includes being able to accurately reproduce the record in its original form.
  5. Security Measures: Implement robust cybersecurity measures to protect against unauthorized access, alteration, or destruction of electronic records. This includes using firewalls, encryption, and secure user authentication methods.
  6. Provide Consumer Protections: Ensure that consumers have the option to receive paper records and can withdraw their consent to electronic records at any time.
  7. Legal and Regulatory Updates: Keep abreast of any updates or changes in the legal and regulatory landscape regarding electronic transactions and records. Adjust policies and practices accordingly to remain compliant.

CONCLUSION:

While e-signatures offer significant benefits for modern commerce, including efficiency and convenience, their adoption requires careful consideration, especially regarding legal and regulatory compliance. By adhering to best practices and remaining vigilant, businesses and individuals can leverage e-signatures effectively in today’s digital economy.

© 2024 SHERIN AND LODGEN LLP
For more news on Financial Institution Legal Compliance, visit the NLR Financial Institutions & Banking section.

UK Regulators Publish Final Securitisation Rules

On 30 April 2024, the Financial Conduct Authority (FCA) published a policy statement (PS24/4) setting out its final firm-facing rules relating to securitisations and summarising feedback to its earlier consultation for the UK securitisation markets (CP23/17). The Prudential Regulation Authority (PRA and together with the FCA, the Regulators) also published a policy statement, in parallel with PS24/4, on its final firm-facing rules for those firms over which it has supervisory responsibility (PS7/24). This also follows the PRA’s own parallel consultation (CP15/23).

Background 

As part of the UK’s post-Brexit regulatory reforms, the UK government is working to repeal and replace retained EU financial services law with new UK domestic rules. In July 2023, the UK government published a draft statutory instrument (SI) to replace the UK’s onshored version of the Securitisation Regulation (UK SR).

Following the publication of the SI, the PRA launched CP15/23 on its proposed firm-facing requirements on 27 July 2023 and the FCA launched its parallel consultation CP23/17 on 7 August 2023. Both of these consultations are explored in further detail in our previous article (available here). While there is some duplication between the two rulebooks, the Regulators noted that they have coordinated their approach with a view to creating a coherent framework.

The Final Rules 

In PS24/4, the FCA has sought, among other things, to incorporate the feedback received on its draft rule proposals set out in its final rules, which are called the ‘Securitisation (Smarter Regulatory Framework and Consequential Amendments) Instrument 2024’.

PS24/4 makes the following key amendments to CP23/17:

  1. Timeline for implementation. The Regulators have confirmed the implementation timeline for the requirements (see the Next Steps section below), which allows for a six-month transition period for pre-implementation securitisations.
  2. Due diligence – public vs private securitisations. The FCA has adjusted the wording of its final rules to accommodate both public and private securitisations. Specifically, they refer to information provided ‘before pricing or original commitment to invest’ (in appropriate places) to reflect that private securitisations do not have “pricings” per se. In addition, the FCA has included guidance to reflect the fact that ‘pricing’ in the Simple, Transparent and Standardised (STS) template is to be understood as also including the ‘original commitment to invest’.
  3. Due diligence – disclosures by ‘manufacturers’. The FCA has adjusted the due diligence requirements for secondary market investors in relation to disclosures made by ‘manufacturers’ (i.e., the term used by the FCA as shorthand for originators, original lenders, sponsors and/or securitisation special purpose entities, each as defined in the UK SR) by:
    i) introducing a distinction between primary and secondary market investments, so that secondary market investors are not required to conduct due diligence on documents and information that are no longer relevant (e.g., information provided prior to initial pricing such as at issuance, etc.); and
    ii) clarifying that investors are required to conduct due diligence on the most up-to-date information available at the time of the investment, as opposed to documents from the timing of ‘pricing’ or ‘commitment’.
  4. Delegation. The FCA has clarified that it is possible for an institutional investor to delegate its due diligence requirements to an entity that is not an institutional investor, subject to the institutional investor retaining the responsibility for compliance with due diligence requirements. In practice, this means that institutional investors will no longer be able to delegate the responsibility for compliance with the due diligence requirements to AIFMs that are not authorised in the UK, as such AIFMs no longer fall within the definition of an ‘institutional investor’ under the SI.
  5. Risk-retention. The FCA has clarified the scope of the prohibition on hedging of the material net interest required to be retained under the risk retention requirements. Specifically, the FCA has confirmed that hedging in these circumstances is permitted for institutional investors so long as it does not compromise the alignment of interest, in line with the EU’s Risk Retention Technical Standards (Commission Delegated Regulation (EU) 2023/2175). In addition, the FCA confirms that there is no need for risk retention in the context of securitisations of own-issued debt instruments, including covered bonds.
  6. Alignment with the PRA. PS24/4 aligns its drafting with that of the PRA rulebook in areas where the rules are similar – both in the language and ordering of the FCA’s rules. The FCA has stated that in a number of cases, however, it has retained the language on which it consulted where, for example, it considered it provided clarity. In non-shared areas, such as STS provisions, the FCA has retained the language and structure of the rules as proposed in CP23/17.

The FCA’s final rules will be included in the FCA’s securitisation sourcebook (known as SECN) alongside the final FCA securitsation reporting templates, which are in the same form as those currently in effect. Similarly, the PRA’s final rules will be implemented into the PRA rulebook by adding a new Securitisation Part, with consequential amendments to the Liquidity Coverage Ratio (CRR) Part and the Non-Performing Exposures Securitisation (CRR) Part.

Next Steps 

The implementation date for the FCA and PRA rules is 1 November 2024, subject to revocation of the UK SR and related technical standards.

The commencement order that will bring into force the revocation of the UK SR and related technical standards has not yet been laid before Parliament. HM Treasury anticipates making this commencement order later this year once the SI comes into force. The FCA has stated that it will consider delaying or revoking the rules if the commencement order is not made.

The Regulators plan to consult on further changes to their securitisation rules in Q4 2024/Q1 2025, although timings are potentially subject to change. In this second consultation, the Regulators plan to review the definition of public and private securitisations and the associated reporting regime, among other areas for policy consideration.

EU Divergence

HM Treasury and the Regulators have generally sought to retain the existing onshored Securitisation Regulation and associated technical standards in the FCA and PRA rulebooks, save for some targeted adjustments. These adjustments will lead to some potentially notable divergence between the UK’s new regime and the regime in the EU, including in relation to the following:

  • Template requirements. While the EU requires institutional investors to ensure disclosure templates are completed regardless of whether the sponsor, originator or SSPE are located in or outside of the EU, UK institutional investors are only required to ensure that certain prescribed information is provided, regardless of the format. Instead, UK sponsors, originators and SSPEs are under a separate obligation to comply with transparency requirements including the use of disclosure templates.
  • Originator sole purpose test. SECN references certain factors to be taken into account when assessing whether an originator has been established and is operating for the “sole purpose” of securitising exposures. The EU regime has a similar test, but focuses on whether the securitisation and related risk retention assets are the “sole or predominant source of revenue” of the originator. The UK’s regime does not set the same hurdle for meeting the sole purpose test, instead referring more generally to the retainer’s ability to meet its payment obligations.
  • Change of risk retainer. Under the EU’s rules the holder of a retained interest may not sell, transfer or otherwise surrender its rights in relation to the retained interest, unless due to its insolvency, “legal reasons beyond its control”, or where there is retention on a consolidated basis. The new UK regime does not include “legal reasons beyond its control” as a reason to disapply the sale restriction.

PS24/4, PS7/24, CP23/17, and CP15/23 can be found here, here, here and here, respectively.

©2024 Katten Muchin Rosenman LLP
For more news on FCA Securitisation Rules, visit the NLR Financial Institutions & Banking section.

Death, Taxes, and Crypto Reporting – The Three Things You Cannot Escape

The IRS released a draft of Form 1099-DA “Digital Asset Proceeds from Broker Transactions” in April which will require anyone defined as a “broker” to report certain information related to the sale of digital assets. The new reporting requirements will be effective for transactions occurring in 2025 and beyond. The release of Form 1099-DA follows a change in the tax law.

In 2021, Congress amended code section 6045 to define “broker” to include any “person who (for consideration) is responsible for regularly providing any service effectuating transfers of digital assets on behalf of another person.” This is an expansion of the definition of a “broker.” The language ‘any service effectuating transfers of digital assets’ is oftentimes construed by many in the tax practitioner community as a catch-all term, in which the government could use to determine many people involved in digital asset platforms aa “brokers.”

The IRS proposed new regulations in August 2023 to further define and clarify the new reporting requirements. Under the proposed regulations, Form 1099-DA reporting would be required even for noncustodial transactions including facilitative services if the provider is in a “position to know” the identity of the seller and the nature of the transaction giving rise to gross proceeds. With apparently no discernible limits, facilitative services include “services that directly or indirectly effectuate a sale of digital assets.” Position to know means “the ability” to “request” a user’s identifying information and to determine whether a transaction gives rise to gross proceeds. Under these proposed regulations and the expanded definition of “broker,” a significant number of transactions that previously did not require 1099 reporting will now require reporting. There has been pushback against these proposed regulations, but the IRS appears determined to move forward with these additional reporting requirements.

Copyright ©2024 Nelson Mullins Riley & Scarborough LLP
For more news on Taxes and Crypto Reporting, visit the NLR Tax section.

Anti-Money Laundering and Sanctions Whistleblower Reward Program is a Force-Multiplier to Detect and Combat Terrorist Financing

Anti-Money Laundering and Sanctions Whistleblower Program

In a May 6, 2024 speech at the SIFMA AML Conference, the Director of the Department of the Treasury’s Financial Crimes Enforcement Network (FinCEN) Andrea Gacki discussed the success of the Anti-Money Laundering Act (AMLA) in generating disclosures about money laundering and sanctions evasion:

[The whistleblower] program holds tremendous potential as an enforcement force-multiplier. Whistleblowers have submitted information relating to some of the most pressing policy objectives of the United States, from Iran- and Russia-related sanctions evasion to drug-trafficking to cyber-crimes and corruption. While efforts are underway to develop an online tip intake portal and other aspects of this important program, I want to note that even while these efforts are underway, the program is actively receiving, reviewing, and sharing tips with our enforcement partners.

We have received over 270 unique tips since the program’s inception, and many of the tips received have been highly relevant to many of Treasury’s top priorities.

The AMLA incentivizes whistleblowers to report money laundering and sanctions evasion by requiring the Department of the Treasury to pay an award where a whistleblower’s voluntary disclosure of original information leads to a successful enforcement action imposing monetary sanctions above $1,000,000. The minimum whistleblower award is ten percent of collected monetary sanctions and the maximum award is thirty percent. Awards are paid from penalties collected in successful enforcement actions stemming from whistleblower disclosures.

To determine the amount of an AMLA whistleblower award, Treasury will consider:

  • the significance of the information provided by the whistleblower to the success of the covered money laundering judicial or administrative action;
  • the degree of assistance provided by the whistleblower and any legal representative;
  • the programmatic interest of Treasury in deterring the particular violations that the whistleblower disclosed; and
  • additional relevant factors that Treasury will promulgate, which will likely echo the factors that the SEC employs to determine the amount of an SEC whistleblower award.

FinCEN Issues Advisory About Terrorist Financing

Among the violations that whistleblowers can help the government detect and combat are sanctions evasion and money laundering related to Islamic Republic of Iran-backed terrorist organizations. On May 8, 2024, FinCEN issued an Advisory to assist financial institutions in detecting potentially illicit transactions related to Islamic Republic of Iran-backed terrorist organizations. FinCEN Advisory to Financial Institutions to Counter the Financing of Iran-Backed Terrorist Organizations, FIN-2024-A001 (May 8, 2024).

The Advisory identifies the means by which certain terrorist organizations receive support from Iran and the techniques they use to illicitly access or circumvent the international financial system to raise, move, and spend funds. According to the Advisory, the sale of commodities, particularly oil, is the primary source of revenue for Iran to fund its terrorist proxies. Iran has “established large-scale global oil smuggling and money laundering networks to enable access to foreign currency and the international financial system through the illicit sale of crude oil and petroleum products in global markets.” FIN-2024-A001, at 3. In 2021, the National Iranian Oil Company sold approximately $40 billion worth of petroleum products and in 2023, Iran’s exports to the People’s Republic of China reached approximately 1.3 million barrels per day. Some of the proceeds of the sale of Iranian oil finances the activities of the IRGC-Qods Force and other terrorist groups.

Financial Institutions Can Serve as Intermediates for Terrorist Financing Transactions

Financial institutions located outside Iran become intermediaries for the IRGC-QF’s terrorist financing transactions. In particular, “third-country front companies—often incorporated as ‘trading companies’ or ‘general trading companies’—and exchange houses act as a global ‘shadow banking’ network that processes illicit commercial transactions and channels money to terrorist organizations on Iran’s behalf.” Those exchange houses and front companies rely on banks with correspondent accounts with U.S. financial institutions, especially to process dollar-denominated transactions. FIN-2024-A001, at 5.

The Advisory lists red flags of illicit or suspicious activity that financial institutions should consider in determining if a behavior or transaction is indicative of terrorist finance or is otherwise suspicious and therefore may warrant the filing of a Suspicious Activity Report:

  • A customer or a customer’s counterparty conducts transactions with Office of Foreign Assets Control (OFAC)-designated entities and individuals, or transactions that contain a nexus to identifiers listed for OFAC-designated entities and individuals, to include email addresses, physical addresses, phone numbers, passport numbers, or CVC addresses.
  • Information included in a transaction between customers or in a note accompanying a peer-to-peer transfer include key terms known to be associated with terrorism or terrorist organizations.
  • A customer conducts transactions with a money services business (MSB) or other financial institution, including a VASP, that operates in jurisdictions known for, or at high risk for, terrorist activity and is reasonably believed to have lax customer identification and verification processes, opaque ownership, or otherwise fails to comply with AML/CFT best practices.
  • A customer conducts transactions that originate with, are directed to, or otherwise involve entities that are front companies, general “trading companies” with unclear business purposes, or other companies whose beneficial ownership information indicates that they may have a nexus with Iran or other Iran-supported terrorist groups. Indicators of possible front companies include opaque ownership structures, individuals and/or entities with obscure names that direct the company, or business addresses that are residential or co-located with other companies.
  • A customer that is or purports to be a charitable organization or NPO84 solicits donations but does not appear to provide any charitable services or openly supports terrorist activity or operations. In some cases, these organizations may post on social media platforms or encrypted messaging apps to solicit donations, including in CVC.
  • A customer receives numerous small CVC payments from many wallets, then transfers the funds to another wallet, particularly if the customer logs in using an Internet Protocol (IP) based in a jurisdiction known for, or at high risk for, terrorist activity. In such cases, financial institutions may also be able to provide associated technical details such as IP addresses with time stamps and device identifiers that can provide helpful information to authorities.
  • A customer makes money transfers to a jurisdiction known for, or at high risk for, terrorist activity that are inconsistent with their stated occupation or business purpose with vague stated purposes such as “travel expenses,” “charity,” “aid,” or “gifts.
  • A customer account receives large payouts from social media fundraisers or crowdfunding platforms and is then accessed from an IP address in a jurisdiction known for, or at high risk for, terrorist activity, particularly if the social media accounts that contribute to the fundraisers contain content supportive of terrorist campaigns.
  • A customer company is incorporated in the United States or a third-country jurisdiction, but its activities occur solely in jurisdictions known for, or at high risk for, terrorist activity and show no relationship to the company’s stated business purpose.

FIN-2024-A001, at 12-13.

© 2024 Zuckerman Law
For more news on the Anti-Money Laundering and Sanctions Whistleblower Reward Program, visit the NLR Criminal Law / Business Crimes section.

CFTC Releases Artificial Intelligence Report

On 2 May 2024, the Commodity Futures Trading Commission’s (CFTC) Technology Advisory Committee (Committee) released a report entitled Responsible AI in Financial Markets: Opportunities, Risks & Recommendations. The report discusses the impact and future implications of artificial intelligence (AI) on financial markets and further illustrates the CFTC’s desire to oversee the AI space.

In the accompanying press release, Commissioner Goldsmith Romero highlighted the significance of the Committee’s recommendations, acknowledging decades of AI use in financial markets and proposing that new challenges will arise with the development of generative AI. Importantly, the report proposes that the CFTC develop a sector-specific AI Risk Management Framework addressing AI-associated risks.

The Committee opined that, without proper industry engagement and regulatory guardrails, the use of AI could “erode public trust in financial markets.” The report outlines potential risks associated with AI in financial markets such as the lack of transparency in AI decision processes, data handling errors, and the potential reinforcement of existing biases.

The report recommends that the CFTC host public roundtable discussions to foster a deeper understanding of AI’s role in financial markets and develop an AI Risk Management Framework for CTFC-registered entities aligned with the National Institute of Standards and Technology’s AI Risk Management Framework. This approach aims to enhance the transparency and reliability of AI systems in financial settings.

The report also calls for continued collaboration across federal agencies and stresses the importance of developing internal AI expertise within the CFTC. It advocates for responsible and transparent AI usage that adheres to ethical standards to ensure the stability and integrity of financial markets.

Copyright 2024 K & L Gates
For more news on AI in Financial Markets, visit the NLR Financial Institutions & Banking section.